Should You Treat Your Social Security Benefits Like a Bond?

As you may know, one of your most important investment decisions has to do with asset allocation — that is, how much of your portfolio should be invested in various asset classes, such as stocks and bonds. The optimal answer has mostly to do with your age and risk tolerance.

When you're young, you have time to ride out the market's ups and downs, so it's generally best to tilt your portfolio toward riskier but potentially more rewarding investments, such as stocks. As you get older, it's wise to change that mix, reducing your stock exposure and increasing your use of less volatile investments, such as bonds.

Your risk tolerance also plays a role. If you're comfortable with risk, that may point you toward a more stock-heavy portfolio. If you prefer the safer side of the spectrum, you may want a more conservative investment mix.

But here's where our esoteric-sounding opening question comes in: What if you could put a present value on your future Social Security benefits? And what if you added that amount to your current investment portfolio? That would make your portfolio much larger, and it would change how you're investing, which is exactly what investing legend and Vanguard Founder Jack Bogle recommends. (See also: The Basics of Asset Allocation)

Running the numbers

Let's say you have investments totaling $450,000 and your optimal asset allocation is 60 percent stocks and 40 percent bonds. That means you should have $270,000 invested in stocks and $180,000 in bonds.

Let's also assume your estimated Social Security benefits will be $1,250 per month, or $15,000 per year, beginning at age 67 (you can see your estimated benefits by making an account the Social Security Administration's website). This exercise also requires that you make an assumption about your life expectancy; let's assume you'll live another 20 years after you start collecting Social Security.

Bogle would suggest valuing your portfolio at $750,000. That's $450,000 of actual investments plus $300,000 of assumed future Social Security benefits ($15,000 per year times 20 years). There are other ways of determining the present value of your future benefits, but taking the annual estimated benefit amount and multiplying it by the number of years you expect to live after starting to claim benefits is the simplest.

Applying a 60/40 allocation to your newly inflated $750,000 portfolio would mean your optimal investment mix is $450,000 in stocks and $300,000 in bonds. Bogle suggests that since Social Security is a virtually guaranteed benefit, that $300,000 "asset" is a conservative asset — more like a bond than a stock. That means you're free to invest your entire actual $450,000 portfolio in stocks. (See also: 7 Reasons You're Never Too Old to Buy Stocks)

What could go wrong?

Proponents of this idea, such as Bogle, point out that the much more aggressive approach it would enable you to take with your actual investments would give you the potential to grow your nest egg much larger. Historically, stocks have far outperformed bonds, so in theory that's correct.

However, it would also mean taking on much more risk than you are right now and having to endure much more volatility than you may be comfortable with, especially as you get older. For example, how would you like to be 65 years old, have your entire retirement portfolio invested in equities, go through a bear market similar to 2008, and lose 50 percent?

Plus, let's say that leaving an inheritance is important to you. What if you go through a 2008-style bear market when you're in your 60s or 70s and that assumption you made about living to age 87 doesn't work so well? The only part of your portfolio that would be left behind is your actual portfolio, which just got cut in half.

What about the rest of your portfolio — the $300,000 of future Social Security benefits? The minute you die, the value of those benefits drops to $0. Are you comfortable with that?

One more concern is whether Social Security will even exist by the time you retire. While it's hard to imagine the organization ever completely disappearing, it's much easier to envision a day when benefits will be reduced based on household income — so-called means testing. The amount of money current workers are paying into the program simply isn't enough to continue paying beneficiaries the full amount they are owed indefinitely.

Not for the faint of heart

Only if you are extremely risk tolerant should you consider factoring future Social Security benefits into your asset allocation. Even then, you would be wise to factor in only a portion of those benefits.

For most, however, because of the added stress this approach would bring, especially at a time of life when peace of mind will be increasingly important, it probably doesn't make sense.

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